Contract Theory & Corporate Governance
Aghion-Bolton Contingent Control & Covenant Formula
Model Philippe Aghion and Patrick Bolton’s (1992) incomplete-contract pecking order across entrepreneur control, debt-covenant state-contingent control, and investor control.
Understand why debt covenants shift control to creditors only in bad states!
Philippe Aghion and Patrick Bolton (1992) explained why financial securities allocate control rights rather than just cash-flow shares! When future operating actions (Continuation vs Liquidation) cannot be specified ex ante in a complete contract, Entrepreneur Control maximizes monetary return PLUS non-pledgeable private benefits b > 0 (risking inefficient continuation in distress), whereas Investor Control maximizes verifiable monetary payoff Y alone (risking premature liquidation in good states when private continuation value b_G is high)!
Verify on Required_Capital K = 140 (B2), Good_State_Prob p = 0.70 (B3), Good_Cont_Cash Y_Gc = 170 (B4) + Good_Private_Benefit b_G = 40 (B5, Total = 210 > Good_Liq_Cash Y_Gl = 180 in B6), and Bad_Cont_Cash Y_Bc = 40 (B7) + Bad_Private_Benefit b_B = 30 (B8, Total = 70 < Bad_Liq_Cash Y_Bl = 90 in B9): (1) Entrepreneur Unilateral Control continues in both states, yielding Max Pledgeable Cash 0.70*170 + 0.30*40 = 131.00 < K = 140 (Unfundable!); (2) Investor Unilateral Control liquidates in both states (180 > 170 and 90 > 40), raising 0.70*180 + 0.30*90 = 153.00 >= 140 but sacrificing b_G = 40 in good states for Net Social NPV = 153 - 140 = +13.00; (3) Debt with Contingent Covenant Control keeps Entrepreneur in charge in Good states (Continuation -> Cash 170, Surplus 210) and shifts control to Creditors upon Bad-state covenant breach (Liquidation -> Cash 90, Surplus 90), achieving Pledgeable Cash 0.70*170 + 0.30*90 = 146.00 >= 140 and First-Best Net Social NPV = (0.70*210 + 0.30*90) - 140 = 174 - 140 = +34.00 (+21.00 covenant efficiency gain)!
| Governance Allocation Regime (K=140, p=0.70) | Max Pledgeable Cash | Net Social NPV |
|---|---|---|
| Entrepreneur Control (Non-Voting Equity) | 131.00 (< 140 Unfundable) | Credit Rationed |
| Investor Control (Voting Outside Equity) | 153.00 (>= 140 Fundable) | +13.00 (Good State Liquidated) |
| Contingent Debt Covenant Control | 146.00 (>= 140 Fundable) | +34.00 (First-Best Achieved) |
| High-Capital Squeeze (K = 150) | 146.00 (< 150 Covenant Short) | Must Cede Investor Control (+3.00) |
Contingent-Control Pledgeable Cash Capacity Formula
Compare Entrepreneur Pledgeable Cash E2 (131.00), Covenant Contingent Cash E4 (146.00), and Investor Pledgeable Cash (153.00) against K (B2)!
=LET(k_cp, B2, p_gd, B3, yg_c, B4, bg_p, B5, yg_l, B6, yb_c, B7, bb_p, B8, yb_l, B9, IF(OR(k_cp <= 0, p_gd <= 0, p_gd >= 1, bg_p < 0, bb_p < 0), "Invalid Control Input", ROUND(p_gd * yg_c + (1 - p_gd) * yb_l, 2)))Optimal Aghion-Bolton Governance Regime & Net Social NPV Formula
Raise K to 150 in B2 to verify the exact Aghion-Bolton shift from Contingent Debt Control to Full Investor Control when pledgeable covenant cash (146) falls short of K (150)!
=IF(ISTEXT(E4), E4, IF(E4 >= B2, ROUND(B3 * (B4 + B5) + (1 - B3) * B9 - B2, 2), "Credit Rationed Under Covenant"))Try the example
Use the original values or change them to test your understanding.